Analysis of developments in financial markets, economics and public policy geared towards anyone with a stake in these issues......and, yes, we all have one.

Monday, June 2, 2014

Commodities in 2014: A Place in the Portfolio?

At a conference in 2007, a speaker initiated
the proceedings by posing the question “what
are the most expensive words in the English language?”The answer to this was “it’s different this time.” The subject of the event was
commodities, namely whether or not the space had developed sufficiently to be
considered a viable asset class and a beneficial component of investors’
portfolios. During those heady pre-crisis days, the winds indeed appeared to be
at the back of investing in raw materials. So much so that experts filled
investment notes and the financial press with talk of a commodities super-cycle, driven by shifting
supply/demand dynamics and rising investor appetite, partly fueled by the
proliferation of new, accessible products.

During the crisis and its immediate
aftermath, the bullish case for commodities remained largely intact. This was
the period when emerging markets…a theme related to commodities demand….were
the engine that kept the global economy (barely) treading water. Aggressive
monetary policy also provided support to the commodities space as investors
ventured farther out along the risk spectrum in search of yield. A key attraction
to commodities during the roaring 2000s was that they had become a viable
source of returns, something that had eluded the asset class for decades. Since the initial post-crash period, which
was marked by the binary risk-on /
risk-off trade, with Treasuries encompassing the latter and nearly
everything else mindlessly lumped into the former, markets have shown greater
differentiation among asset class performance.
And during these past three years commodities have really taken it on
the chin.

As seen in the table above, even as
equities have sailed along at nearly a 16% annualized clip, total returns for
the broad S&P GSCI commodities index have dipped into the red, with the
agriculture and industrial metals buckets especially getting pummeled. Now, with U.S. equity indices hovering near
record highs, developed market bond yields at historic lows and trillions of
dollars in fiat money lurking in the shadows, an investor must ask if dialing
up commodities exposure at this time may at least in part address some of these
sources of consternation.

A history lesson

Long considered a niche investment,
commodities as an asset class have exhibited characteristics over the decades
that were attractive to investors. They lacked correlation to major asset
classes like equities and fixed income, meaning they could provide
diversification when included in portfolios. Not coincidently, they tended to
be positively correlated to the bane of many investments: inflation. The logic was that rising raw materials
prices squeezed corporate margins, thus diminishing the present value of a
firm’s future cash flow, which by definition meant a lower stock price.
Moderate inflation, driven by increased demand accompanying robust economic
growth could allow both input costs (e.g. commodities) and stock prices to rise
in lock step, but only up to a certain point before consumers get squeezed and
snap shut their wallets. Conversely, inflation caused by an adverse supply
shock of key raw materials…so-called cost-push inflation….seldom bodes well for
stocks. Similarly, inflation and bonds are akin to oil and water. Any whiff of upward
price pressure, regardless of the source, usually sends bond investors fleeing.

The downside to this inflation
hedge and lack of correlation has been the volatility inherent in commodities,
the difficulty in accessing them (historically available mainly through futures
contracts and the physical market), and perhaps most importantly, the absence
of any respectable yield. In fact, not only does a hunk of metal or bushel of
corn not pay a coupon or a dividend, but investors often incur holding costs
such as those for storage or rolling over expiring futures contracts, which
were priced lower than farther-dated replacements. Why were yields historically paltry? A simple
answer is supply and demand: For much of the 20th century, there was
plenty of easy-to-find oil, copper and arable land. As long as balances favored
supply, it was difficult for raw materials prices to go on a sustained tear.
Either producers would bring more product to market to meet increased demand or
incipient inflation would sour consumers’ appetites in what industry-types call
demand-destruction.

What fractured this status quo was, in a word,
China. Over the past three decades much of the world’s manufacturing capacity
was relocated this rising giant and to other low-cost countries. The industrial
base of these developing nations was less than efficient, meaning for every
unit of output, a greater amount of inputs was required vis-à-vis developed
markets. This was true for energy consumption, the utilization of metals and an
array of other raw materials. The lack of efficiency also applied to
nonexistent pollution standards, but no worries, none of that toxic air drifted
across the Pacific. Right.

At the same time these countries
were updating infrastructure and housing, increasing demand for construction
materials such as copper, steel and electricity (city dwellers are more energy
intensive than country folk). Not to be left out, demand for agricultural
commodities increased as large populations switched to protein-based diets,
which paradoxically, require a greater amount of crops like soybeans and corn
to fatten up cows and hogs for slaughter.

At the same time…..this was prior
to the shale revolution sent from above….cheap sources of raw materials began
to peter out. The crude, copper and aluminum were still there, but these
harder-to-access materials required additional expenses in R&D, exploration
and extraction, thus pushing up marginal costs. It was the confluence of this
increased demand inconveniently occurring as supplies were pressured that lent
credence to the super-cycle premise.
Sensing there was a buck to be made, the investment community funneled cash to
commodities firms to develop new resources; they also became active
participants in the physical and futures markets. Why a bank needs to own a
warehouse full of zinc is beyond me. But they did, resulting in increased
demand from financial…or speculative…players, who bought raw materials not to
produce anything, but simply to flip them and keep the profit.

The Shakeout

But this increased investor
attention led to an increased correlation between commodities and other risky
assets such as equities, undercutting one of the primary attractions of
commodities in the first place. The measures undertaken in the wake of the
financial crisis reinforced this development as yield-starved investors lumped
all riskier…thus higher yielding….asset classes into the same bucket. Rock-bottom
interest rates also played a role by making it cheaper to finance
highly-levered commodities futures. As evidenced in the chart below, beginning
in late 2008, the historical lack of correlation between equities and
commodities abruptly rose to a range consistently above 0.50.

Since the depths of the financial
crisis, it is safe to say that financial markets have returned but the economy
hasn’t. This dynamic is represented by commodities, as measured by the S&P
GSCI index, having traded sideways since mid-2011. Over the long-term,
supply/demand fundamentals (theoretically….a
loaded word) determine the prices for raw materials, and without robust growth
in major economies, the 2009-2011 rally proved impossible to sustain. The
divergence in fortunes between commodities and equities is also a reminder that
increased correlation refers only to direction and not magnitude.

Speaking of markets

Another knock against the increase
in speculative investors…as opposed to commercial users of physical commodities….is
that often their allocation decisions are driven by macroeconomic developments
rather than fundamentals. Yes, the participation of a certain amount of
financial players increases liquidity, thus market functionality, but when
taken too far, it distorts necessary signals from underlying supply/demand
dynamics. This was certainly the case in the two years immediately following
the crisis when the broad S&P GSCI returned a total of 25% and the energy,
industrial metals and agricultural buckets returned 20%, 70% and 32% respectively.
Since then, the broad index has returned -6%, with metals and crops getting especially
routed.

Certain segments of the commodities
universe are more tightly tied to economic growth. It should come as no
surprise then that two such sectors, energy and industrial metals, have suffered
over the past three years as global growth remains elusive. As seen below,
growth since 2010 has been on a downward trajectory for most global regions. Of
special concern is the lower rate of expansion in emerging markets, which had
been the shining star after the crisis.

With economies stuck in low gear, inflation
remains muted. While the Fed’s favored inflation gauge (below) ticked up to
1.6% year-on-year in April, the rolling three-month average is still a minuscule
1.2%, far below the 2.5% that they would happily accept. At the same time, the
Eurozone is flirting with deflation. It says a lot when Japan is more effective
in stoking upward price pressure than its advanced economy peers. Without any
inflationary pressure to hedge, a further rationale for commodities exposure
has been reduced.

Falling short of the promise

As it stands, commodities exposure
is not delivering what it has historically promised. Correlations with other
risky assets are elevated, meaning there are few benefits of portfolio diversification.
Even if the eventual curtailment of loose monetary policy chases away a large
amount of speculative investors…in turn lowering correlations…other merits of
owning commodities in the present environment also ring hollow. Inflation
remains muted and with global growth stuck in a rut, commercial demand for industrial
inputs will fail to match the rates registered earlier in the millennium. In
such a scenario, investors may as well chase asset classes like equities, which
despite dubious fundamentals, at least generate juicy returns.

The genie however is out of the
bottle and exposure to raw materials should remain on investors’ radar screens,
if not in their portfolios at present. Across the commodities universe, the new
sources brought online after the latest round of investment largely have higher
marginal costs than the fields, wells and mines of yesteryear. This provides a
price floor to many different resources. And if central banks get behind the curve of controlling upward
price pressure due to the mountains of money created to combat slow growth,
then the need for an inflationary hedge may indeed reappear, especially if
economic growth forecasts surprise to the upside…..but let’s not hold our
breath for that.

For those itching to for
commodities exposure today, one avenue is via the shares of commodities
producers. Historically these tend to be more correlated with the overall equities
market rather than physical market, but they are naturally levered (thanks to
firms’ balance sheets) and they’ve been outperforming the broader market of
late. Year to date, the energy sector of the S&P 500 has returned 7.5%
(including dividends), outpacing the 5% of the broader index. Materials, meanwhile
have returned a respectable 6.8% year-to-date. And there still may be more room
to the upside as both sectors lagged well behind the S&P 500 over the past
three years, with materials and energy returning 10.3% and 9.1% (annualized)
compared to the 15.2% registered by the broader S&P. And as evidenced by
certain segments of the physical market having tanked of late, investors may
finally be differentiating between slices with favorable and unfavorable
fundamentals. While not a complete
return to normalcy, this development means that those who do their homework can
be rewarded. The key is to identify resources
with long-term favorable demand dynamics and whose current prices are not too
far above the marginal costs of production, which in part may contribute to
limiting downside risk.

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About Me

During my career as an investment analyst, several developments from the realms of financial markets, economics and public policy struck me as highly relevant, not to me in my role as a market observer, but in my role as a citizen. The subjects covered on these pages are not aimed at fellow investors or policy junkies, but to the broader population, which needs to recognize the shifts occuring in the economy and understand their consequences, as well as those of government policy.